Publications

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Introduction: the Current Economic Environment.
The venture capital environment has significantly changed in the past year. For those companies fortunate enough to see a venture capital term sheet, valuations have been all too humbling, as venture capitalists, faced with a flood of companies desperately seeking cash in order to survive, are now accustomed to dictating the terms of such financings. Given that the IPO market has become virtually non-existent for most start-ups, the sale of the company has become the expected liquidity event for the venture capitalist. In the recent boom economy, the prices acquirors were willing to pay for a company typically provided more than enough to go around and provided incentive for all parties to favor the transaction. The reduced valuations of today’s economy for companies fortunate enough to even see an acquisition term sheet, however, often leads to a divergence of interests between the parties involved, and sometimes even derails the acquisition. To best position themselves for the complexities of such a liquidity event in today’s economic environment, companies and venture capitalists should carefully consider the financing terms being negotiated and how they may affect the ability to achieve a liquidity event through the acquisition of the company.

Inherent Conflicts Between Investors, Management/Employees and Potential Acquirors.
Liquidation preferences and participation rights are provisions typically negotiated in a venture financing to augment the rights of the preferred shares that venture capitalists purchase. These terms dictate how the purchase price in an acquisition will be divided between the shareholders, and they are typically a primary cause of tension between the preferred and common shareholders, both during financing rounds and in any subsequent sale of the company. A liquidation preference is the amount payable to the holders of preferred stock upon a sale of the company in priority to any payments made to holders of the company’s common stock. A participation right is the right to participate along with holders of the company’s common stock in the sale proceeds remaining after the payout of the liquidation preferences, and is usually capped at a multiple of the purchase price of the preferred stock to which it pertains. In the context of a sale, the division of purchase price among the company’s shareholders is determined by these liquidation preferences and participation rights. The company shareholders owning preferred stock first claim their liquidation preference, and the remainder of the sale proceeds are divvied between the common shareholders, and, if preferred participation rights exist, the preferred shareholders. During the bubble economy, amounts paid by acquirors for the purchase of a company were often more than sufficient to pay in full any existing liquidation preferences along with an additional return through participation rights (and in certain instances were generous enough to result in the preferred holders actually choosing to convert to common stock and foregoing their liquidation preferences). The lower amounts being offered for companies in today’s economy, however, are often not sufficient to even satisfy the liquidation preferences of the preferred stock, leading to the predicament that the common shareholders in such event receive no proceeds from the acquisition at all.

The combination of low acquisition valuations and liquidation preferences which may consume what little sale proceeds are offered leads to two fundamental issues which need to be addressed to successfully complete any sale: first, how to provide the parties with sufficient incentive to favor the sale, and second, how to ensure the retention of the management and other employees the acquiror may be counting on to run the acquired business. Where holders of common stock—generally the employees and founders of the company—are to receive little or nothing with respect to the sale of the company, there may be little incentive for such holders to either vote for the transaction or to stay with the combined company following the transaction. Acquirors often view such management and employees as an integral part of what they are paying for, and therefore also have a vested interest in the distribution of the sale proceeds. If there is substantial risk that key management or employees may leave as a result of the allocation of the distributions, a potential acquiror may lose interest in the purchase. While an acquiror may assist in the process of providing sufficient incentives to the employees using its own compensation packages (e.g., by issuing additional options to such employees after the acquisition), acquirors may not want to have such incentive come out of their pockets in addition to the sale price they are already paying. Therefore, while the preferred holders have an economic incentive to maximize their financial return on their investment and may not have any interest in the ongoing entity, they must simultaneously consider how to facilitate a sale in the context of the interests of the common shareholders as well as a potential acquiror itself.

Financing Mechanisms to Reduce the Conflicts.
To increase the likelihood of a successful liquidity event, investors should contemplate the following considerations during the financing. To reduce the potential for inherent conflicts that may arise at the time of sale, venture capitalists insisting on liquidation preferences which may leave the company’s common stock worthless should consider the use and implications of management carve outs, drag along rights and automatic conversion features. Management carve outs are provisions put into place whereby a certain amount or percentage of future sale proceeds will be set aside for management and other designated employees, and are structured so that any liquidation preferences of the preferred stock are subject to these initial carve out payments. Management carve outs can be an important tool to provide incentive for such individuals to stay with the company and support the transaction. Given the threat that liquidation preferences of the venture capitalists would eliminate or drastically reduce any return to those individuals holding common stock or options exercisable for common stock, such carve outs are designed to provide the economic justification for the recipients to both stay with the company and to maximize the company’s value. When considering such carve outs attention must be paid to tax matters, as by their nature carve outs will generally be treated as compensation income and not capital gain, which would be the treatment amounts received in the acquisition in respect of equity holdings or options.

In addition to predetermining the division of the purchase price, other provisions can be employed to control the mechanics and negotiating dynamics which occur at acquisition time. Drag along rights are rights to force all shareholders to go along with a merger or other acquisition transaction approved by the board of directors or a majority of the investors. Such provisions remove the concern over obtaining the requisite vote to approve the transaction. Automatic conversion provisions permit the holders of a specified percentage (for instance, a majority or two thirds) of the outstanding shares of preferred stock, or alternatively, a specified percentage of the outstanding shares of one or more series of preferred stock, to cause the conversion of all of the outstanding preferred stock or all of the outstanding shares of one or more series of preferred stock, as the case may be, to common stock. Thus, a requisite number of preferred holders can force the others to convert, thereby sacrificing any liquidation preference they may be otherwise entitled to and substantially varying the manner in which the acquisition proceeds are allocated among the various classes of equity holders. These tools can smooth the process and help block strategies whereby a relatively new investor can either unduly hold up a deal or extract unreasonable concessions. The existence of such enabling provisions are important to buyers who generally do not want to get involved in three or more way discussions and always want deals to close as quickly as possible.

Conclusion.
In venture financing negotiations in today’s economic environment, companies and venture capitalists should contemplate the financing terms and considerations set forth above in the context of an eventual acquisition. Each of these provisions takes on increased importance in today’s economy, as the interplay between the provisions will moderate the existing tensions between the interests of the preferred shareholders, the common shareholders and oftentimes the acquiror itself. While a venture capitalist will be asking for liquidation preferences and participation rights that will often lead to little or nothing available for the holders of common stock in the event of an acquisition, along with drag along rights to ensure such an acquisition can occur, such inequalities and resulting issues can be tempered by provisions such as management carve out rights which assist to provide the proper incentives to each of the parties at issue. Finally, investors need to realize that the controlling provisions they negotiate today may, at best, simply improve their leverage at the time of an acquisition when management or other key common stockholder consensus is needed.


Copyright © 2002 Gray Cary Ware & Freidenrich LLP